Etienne Farvaque, Ph.D., Economics, University of Lille 1, Batiment SH2 - Faculte des Sciences Economiques et Sociales, Villeneuve d'Ascq, 59655, France and Norimichi Matsueda, Ph.D., School of Economics, Kwansai Gakuin University, 1-1-155 Uegahara, Nishinomiya, Hyogo 662-8501, Nishinomiya, 662-8501, Japan.
While the literature on Currency Areas has focused on ex ante criteria, ex post criteria are drawing increasing attentions. Starting from Mundell (1961), McKinnon (1963) and Kenen (1969), the literature weighs the benefits of having a common currency against the costs of losing monetary autonomy. If the benefits of a single currency are restricted to a reduction in transaction costs, the benefits are greater when the member countries of the monetary union trade more intensively with each other.
On the other hand, the costs are mainly due to asymmetric shocks. Most of these criteria look at factors inside the new monetary union in investigating into what could or would happen after the introduction of a new currency. For instance, following Frankel and Rose (1997, 1998), studies have stated that countries which would not form an optimum currency area ex ante could evolve by reducing the asymmetry of real output movements. Such an evolution would originate from rationalization of production activities inside the union.
In parallel, it is true that there are two types of monetary unions (Bordo and James, 2008): national and multinational, and the latter has proved more fragile. The conditions of sustainability are not just a purely theoretical question, as is obvious from the demise of the Latin Monetary Union, the Scandinavian, and the Czechoslovakia. Moreover, international monetary unions have been dissolved due to exogenous shocks, such as World War I, and to the strains induced by diverging economic situations. External shocks, be they political or economic, can become a threat to the sustainability of a union. The situation is even more problematic if such shocks are felt as systematically occurring in opposite directions.
In this paper, therefore, besides currency area criteria, we consider how a monetary union can resist to the shocks coming from the rest of the world, especially focusing on the case where these shocks are “diagonally opposed” or “exactly offsetting”.
These types of shocks affect its members in an exactly opposite direction but to the same degree. In this study, we are interested in the conditions under which a monetary union can survive different types of external shocks. As a real-world example, such external shocks, with their corresponding consequences upon the Euro area members’ economies, have created tensions inside the monetary union, and some Italian politicians even reconsidered the benefits of the union, and threatened to exit. Moreover, Favero and Giavazzi (2008) find that the level of long-term rates in Europe is almost entirely explained by U.S. shocks and by the systematic response of U.S. and European variables (inflation, short term rates and the output gap) to these shocks.
In order to analyse the consequences of external shocks on a nation’s commitment to remaining a member of the union, we first build a simple model of a monetary union. Then, we compare the sustainability conditions between the two particular situations: one where external shocks impact its different members differently, and one where its different members have exactly offsetting types of sensitivities to external shocks.